North American Operations business review

Unprecedented catastrophe activity, increased attritional weather claims and an average Crop result following an outstanding 2016 overshadowed further operational progress in North America.

Russ JohnstonChief Executive Officer • North American Operations

Gross writtenpremium (US$M)

4,556

1% from 2016 1

Net earnedpremium 2(US$M)

3,541

7% from 2016

Underwritingresult 2(US$M)

(313)

385M from 2016

Insurance (loss)profit 2(US$M)

(236)

391M from 2016

Combinedoperating ratio 2,3

109.1%

2016 98.5%

Insurance (loss)profit margin 2

(6.7)%

2016 4.7%

Excludes $142 million of Latin American Operations premium income fronted on behalf of Equator Re in 2016.

Adjusted for transactions to reinsure liabilities.

Combined operating ratio adjusted to exclude the impact of changes in risk-free rates used to discount net outstanding claims.

2017 Overview

North American Operations is a specialist insurance and reinsurance franchise focused on four business units: Property & Casualty (P&C), Specialty, Crop and Assumed Reinsurance, with the latter a component of QBE’s global reinsurance business headquartered in London.

Record catastrophe frequency and severity (including increased attritional weather claims) coupled with flat premium rates, rendered 2017 an especially challenging year for both QBE and the North American insurance industry more broadly. Given a sustained soft premium rating environment, it has become increasingly important to drive continued improvement in how we define, target, select and price risk while driving greater efficiency and enhanced customer experience.

In 2017, we took several important actions to embed our strategy to be an integrated specialist insurer:

consolidated and redefined our appetite to focus on “middle market” business in P&C B;

partnered with Arrowhead to enhance our service proposition in small commercial;

redefined our distribution support to be more focused on our limited and preferred distribution partners; and

further strengthened our management team while building a national platform.

North America has established a strong Specialty business with diversification across core segments of accident and health and management and professional lines. Specialty results were adversely impacted by prior accident year claims development, primarily related to accident and health, directors and officers and certain programs that have since been terminated. Notwithstanding adverse weather conditions, our Crop business achieved a solid result. P&C was impacted by significant catastrophe claims and challenges in commercial auto, while results in our Reinsurance business were significantly impacted by catastrophe claims and adverse prior accident year claims development in the casualty portfolio.

During 2017, we completed a further loss portfolio transfer (LPT) of discontinued programs to mitigate the risk of substantial adverse claims development. Together with the LPT undertaken in 2016, we have removed in excess of $850 million of potentially volatile claims liabilities from our balance sheet. The LPTs, coupled with a further $114 million of reserve strengthening, provide us with a strong foundation for improved profitability and reduced earnings volatility as we progress into 2018.

Operating and financial performance

Underwriting performance

The LPT transaction reduced net claims incurred by $311 million and net earned premium by $300 million. In addition to reducing the level of uncertainty in the net discounted central estimate, the LPT adversely impacted North America’s combined operating ratio by 0.6% (with a 2.4% positive impact on the net claims ratio more than offset by a 3.0% adverse impact on the combined commission and expense ratio).

To assist year on year comparability, the underwriting performance commentary hereafter refers to the 2017 and 2016 results excluding the impact of the LPT transaction.

North America reported a combined operating ratio of 108.8%, up from 97.8% in the prior year. The underwriting result includes a benefit of $11 million or 0.3% of net earned premium due to higher risk-free rates used to discount net outstanding claims compared with a benefit of $21 million or 0.6% in the prior year. Excluding this benefit, the combined operating ratio was 109.1%, up materially from 98.5% a year earlier.

Gross and net large individual risk and catastrophe claims amounted to $726 million and $418 million respectively driven by Hurricanes Harvey, Irma and Maria and California wildfires. Total catastrophe activity, which also includes hail and convective storm activity during the first half, contributed 9.2% to the combined operating ratio compared with only 3.7% in 2016. Large individual risk and catastrophe claims retained in excess of divisional aggregate reinsurance added 6.9% to the combined operating ratio.

Current accident year underwriting profitability in our key segments remains strong. The Crop business achieved an average underwriting result with modest growth in policy count, coverage and higher commodity prices contributing to gross written premium growth of 14%. We continue to develop our leading Specialty franchise with premium growth of 24% during the year. Within P&C, program premium contracted due to the termination of a heavily catastrophe exposed and underperforming program as well as the termination of commercial auto business as part of the 2016 LPT. The commercial insurance portfolio underwent heavy remediation including the non-renewal of underperforming segments such as commercial auto and corporate primary accounts that was partially offset by growth in targeted industry verticals.

Comparability of prior period data is reduced due to the sale of M&LS.

Combined operating ratio adjusted to exclude the impact of changes in risk-free rates used to discount net outstanding claims. Management-basis results were not reported in 2013.

Premium income

Headline gross written premium declined 2% to $4,556 million from $4,647 million in the prior year but was up 1% excluding Latin American business fronted on behalf of Equator Re in 2016. Average premium rates across the portfolio increased 0.7% compared to flat in the prior year. Although better than the prior year, average premium rates were still below underlying claims inflation.

Growth in Specialty continued with gross written premium up 24% relative to the prior year. New business continued to grow, albeit at a reduced level, with growth across the portfolio including errors and omissions and transactional liability as well as from the addition of new specialty programs to the portfolio. Crop premium increased 14% compared to 2016, reflecting a modest increase in policy count, higher commodity prices and increased coverage.

P&C premium declined 12% driven by continued underwriting action in underperforming areas including the mid-year termination of a severely underperforming and heavily property catastrophe exposed program, coupled with new business shortfalls, primarily in the program business. The commercial insurance portfolio also contracted due to competitive property premium rates and corrective underwriting actions in commercial auto, including the 2016 decision to exit mono-line commercial auto insurance.

Net earned premium increased by 7% to $3,541 million from $3,318 million in the prior year, reflecting significantly reduced reinsurance spend, particularly in Crop.

Gross earned premium by class of business

Claims expense

North American Operations reported a claims ratio of 77.7%, up from 64.2% in the prior year, reflecting record catastrophe activity, a more normal Crop result and a heightened frequency of weather-related attritional claims.

Including Hurricanes Harvey, Irma and Maria, the Californian wildfires and first half hail and convective storm activity, the net cost of large individual risk and catastrophe claims contributed 11.7% to the net claims ratio compared with only 6.4% in 2016.

The attritional claims ratio increased to 58.3% from 52.0% in the prior year, largely due to a more normal Crop result after an outstanding 2016. Excluding Crop, the attritional claims ratio increased 1.6%, reflecting the competitive pricing landscape coupled with heightened weather-related claims frequency as well as the increased contribution from Specialty business that ordinarily operates at a higher attritional claims ratio.

The claims ratio was also impacted by 3.2% or $114 million as a result of claims reserve strengthening in certain portfolios including commercial casualty (particularly in Assumed Re), management liability and a now‑terminated specialty program, partially offset by favourable experience in Crop. This compares with 3.6% or $121 million of adverse prior accident year claims development in 2016.

Commission and expenses

North America’s commission ratio decreased to 15.6% from 17.0% in the prior year, reflecting a significant increase in low commission paying Crop business coupled with a lower proportion of higher commission paying program business and profit share arrangements in our P&C business.

The expense ratio improved to 15.5% from 16.6% in the prior year, reflecting a focus on efficiency that saw costs stable relative to net earned premium growth of 7%. In June 2017, we commenced transitioning the administration of the small commercial book to Arrowhead to leverage its expertise and technology platform. The transition enabled a significant reduction in headcount and will eventually facilitate the decommissioning of a number of legacy policy and claims administration platforms.

Outlook

While the significant weather events of 2017 had a material impact on the industry, the North American market is unfortunately only experiencing a moderate degree of stabilisation of rates in specific classes rather than the broader market response we were hoping for. Although we are disappointed the market hasn’t responded in a more robust manner, we believe our strategy of focusing on specific sectors and using data and analytics to improve risk selection, pricing and deliver exceptional claims outcomes positions us to improve our results in 2018 against that backdrop.

Having stabilised the premium base and resumed targeted growth across industry verticals, further expense management efforts are underway including streamlining and modernising our technology and operating infrastructure consistent with a more simplified business strategy.